Global deflation could provide the next big shock
On world economics
Tuesday 23 September 1997
Part of the justification for the continuing boom in US shares is that the business cycle, though not dead, seems to be more muted than it was in the 1970s and 1980s.
This sort of debate was behind the alarm that greeted the purchase last week by Warren Buffett, the legendary US investor, of a large line of fixed-interest securities. Was he indicating that the share price boom in the US was over and people should therefore shift to bonds?
More of that in a moment. When they are not puzzling about the state of the cycle investors frequently ponder the likely shocks that might disrupt their view of the world. The best-known, perhaps, are the two oil shocks which on two occasions quadrupled the price of oil, but there have been many others. We have had one of those shocks this summer with the collapse of currencies and share prices in East Asia, a fitting background to the IMF and World Bank meetings taking place this week in Hong Kong.
The practical question this shock raises is whether it is serious enough to damage world economic growth. The conventional (and probably correct) response to that is that, on its own, disruption in East Asia is not likely to have a systemic impact beyond the region because the economies affected are not that large yet in relation to global trade. Europe and North America are therefore unlikely to be affected, except insofar as some exports will be lost and a lot of investments will be worth less than their owners previously thought.
But were the downturn to spread to Japan, the impact might become quite serious, as the Japanese economy is not in any shape to withstand a fall in its exports, and East Asia has been its fastest-growing market. For a start it might further undermine the yen, one of the serious concerns voiced at the IMF/World Bank meetings, and Japan might be forced to switch the export drive even more towards the US and Europe, areas with which it already has what the Americans at least feel is an unacceptably large current account surplus.
So these are perfectly legitimate things for investors to fret about. The state of the cycle and the potential shocks matter a lot. But I think that is also worth devoting some space of mind to trying to understand whether we are also experiencing a big global turning point in the very long term trends of the world economy. How might we look back on the last years of this century in another generation's time? Two contributions on this theme seem worth a wider audience.
The McKinsey Quarterly, the journal of the management consultants, has just carried an article by Jane Fraser and Jeremy Oppenheim, which argues that globalisation is about to cause a 50-year irreversible transformation of the world economy. The world, they argue, has already become vastly more international over the last few decades, but they now believe this process will step up several gears. As management consultants, they see this in terms of its impact on company organisation, as companies wanting to operate on a truly global scale will have to change their management structures. But of course, if they are right, there are also profound implications for financial markets. If we really believe that we are at the beginning of a couple of generations of secure, sustained economic growth, then the whole investment outlook is qualitatively different from the volatile world of the last half century.
The other contribution comes from the latest edition of The International Bank Credit Analyst, from the Montreal-based economic consultants, BCA Publications. Much of the work of BCA is based on cyclical analysis, but a long-term question emerges from this: are we facing global deflation?
Start with the simpler question: is there excess demand in the world? The BCA team has taken three measures of demand - industrial production, unemployment and capacity utilisation - from as many countries as it can conveniently collect data and calculated whether the world economy as a whole is on track. The results are shown in the graph, and as you can see it looks pretty much as though everything is evenly balanced. Industrial production and capacity utilisation are very close to balance, while the unemployment measure shows a modest amount of excess demand.
BCA however believes that while the main economies could tilt either way the balance of probability inclines to disinflation. There are no strong signs of inflation at a global level and the events in South-east Asia will be disinflationary as a rapidly-growing part of the world will tend to grow more slowly.
If this is right, it is pretty remarkable. We have experienced a long period of growth in the US (and almost as long in the UK) and are starting to see more signs of growth on the Continent. Yet there are no signs of inflation at a producer price level, even in economies which have been growing fast. British producer prices are up only 1.4 per cent over the last year, while US are down 0.4 per cent. If we can sustain this sort of growth with so little inflation think what might happen when growth comes off. Indeed the world as a whole may well be moving to an era when price stability becomes the norm, and when there are long periods - as there were in the last century - when the long-term trend is for world prices to fall.
Is this global deflation really likely? I don't know the answer but I know the question matters enormously. The world "deflation" has an alarming ring to it, awaking folk-memories of the 1930s Depression. But from any perspective other than the 1930s a period of deflation could be accompanied by solid economic growth. Perhaps we are facing just such a period.
If this proves right,there are profound implications for investors. Bonds will be good investments; there will be few windfall gains from surges in property prices; equities will depend on the earning power of the underlying assets, rather than gaining much of their value as a hedge against inflation. Workers would get much of their higher real wages in the form of falling prices, as is happening in computers and telecommunications charges at the moment, rather than higher wages.
Meanwhile it is hard for us to think in terms of stable prices, let alone falling ones. But it is no harder than it was for people brought up on the second half of the last century to come to terms with the chaos of the first half of this one.
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